the great financial risk crisis 2008-signed

THE GREAT FINANCIAL CRISIS 2008 US RECESSION STORM How pre-crisis period sow the seeds, Bursting of Housing Bubble, Subprime Lending, Recession at its peak, Post crises period and talks, Final Conclusion.

2014

CA PANKAJ Business Consultant

10/8/2014

Pankaj Chhabra [email protected] Business Consultant

THE GREAT FINANCIAL CRISIS 2008

AN INSIGHT TO THE WORLD’S SECOND LARGEST RECESSION

Yes!!! You have read it right. The title of the article itself spoke about the risk and the dynamic

nature of the Business Environment. The storm which hits the world through its power and left its

footprint and the impact in every economists & business analyst’s mind.

The financial crisis of 2007-2008 known as Global Financial Crisis and 2008 Financial Crisis,

considered as the worst recession by the economists since the Great Depression of 1930. It

resulted in to the total collapse of the Financial Institutions, Insolvency of Banks, Downturn of Stock

market, foreclosures and the prolonged unemployment, Decline in the Consumer Wealth estimated

in Trillions U.S Dollar, and contributing to the Europe Sovereign-debt crisis.

The active phase of recession i.e. 2008-2012, manifests itself to the evaporation of liquidity from

the economy. The bursting of Housing Bubble , overvaluation of subprime mortgages, loopholes in

the financial regulation, dramatic failures of risk management and the corporate governance, easily

available borrowings at low interest rates and so on………

I mean what I should say about this interesting story and the research over the same that forced me

to write a detailed article on such a great topic. I have given above a glimpse of the topic which are

going to discuss in detail further. Through this article I would be explaining the causes behind the

recession and the ways to avoid such a situation at the gross root levels. Happy Reading!!

Well, you must have heard of this harsh but true phrase, “don’t blindly believe what you see, the

reality might have been adjusted to comfort the eyes”. This phrase has an utmost relevance as far as

the second largest recession (after the Second World War) is concerned. Most of us have been told

or forced to believe by the news channels that the Global Recession was the result of the sudden

collapse of the Lehman Brothers. But while researching for this article, I was surprised to discover

that the seeds of this disaster had been sown long ago.


We will now discuss further in detail some of the issues like historical perspective leading up to the

crisis, followed by the causes, consequences and the remedial actions taken by the government of

the financial crisis in the form of changes in the policies. Lastly we would focus on the recovery

phase and then the final crux of the whole matter.

INTERPRETING THE PRE-CRISIS PERIOD :

The time when seeds were sown for the crisis, many factors are there which contributed to the same

which today we called as Great Financial crisis. Just similar to the bursting of Volcano, this crisis came in

front of the world after taking energy from the various factors from decades.

1. The lost decades and the Great Moderation:

Unaware of the numerous crises that took place between 1970 & 2008, people used to believe that

all was well between those years. But you would be shocked to know that this period witnessed 124

bank crisis, 63 sovereign debt crises, 42 twin crises, 10 triple crises , a global economic downturn

every 10 years and several price shocks.

Common observations made during the above crises can be presented as follows:

The situation was worse in developing countries where poverty was increasing and real wages were declining.

The 1980s and 1990s were dubbed as the “Lost Decades” as the growth rates in the

developing countries were insufficient. The devastating impact of the surge in oil and food prices on the poor was seen as a crisis before the crisis.

The debt crisis of the 1980s, the Asian financial crisis of the late 1990s and the debt crisis of

in Latin America in the 1990s and the 2000s – all resulted in deep recessions. But the effects were not so visible because of the boom years of 2000s. Poor macro-economic management and policy making resulted in crisis in many developing countries. E.g.: Argentina experienced 4 Banking Crises since 1945.

2. The Synchronized Global Boom Of 2002-2007:

Most of you would be shocked to know that the pre-crisis period between 2002 and 2007 was one of historically high rates of growth, especially for the developing countries.

However, bursting of the 'dot.com bubble' in 2001 resulted in a mild global downturn. But

this was followed by a synchronized boom that lasted until 2007. During the period, Africa grew at unprecedented rates. Unaware of the lurking financial crisis, some economists even marked this as the onset of a “Global Platinum Age.”


The following diagram explains the series of favorable events that could be attributed to the boom period of 2002 to 2007.

The optimism prevailing about the future growth led to an underestimation of risk. Policymakers and development practitioners were unable to figure out the approaching global economic recession whose seeds were being sown in the US heartland.

THE GLOBAL FINANCIAL CRISIS 2007-2009

As evident from the above analysis, it would not be wrong to say that the global economy was by no means as stable as suggested by many observers and economists. It was all like a pretty concocted story where everything was going on smoothly, without anyone being concerned of the underlying roots of the recession which was about to follow, unless the Housing bubble scam of the US busted and the consequential collapse of the Lehman Brothers hit the headlines in September 2008.

The crises unraveled and sucked in at first the banks and companies, further engulfing the

economies across the globe.

It is surprising to discover that even before this recession could spread its web, the 2007-

08 food & energy price shocks had already pushed more than 100 million people in the developing world into transient episodes of poverty. The poor across the world were already suffering from skyrocketing inflation.

The great recession of 2008-09 only added to the woes of the people. The report of the

World Bank stated that it resulted in an increase in the poverty of 64 million people. The main thing to focus was that unlike the food & energy price shocks which mainly affected low & middle income countries, the 2008-09 crises had an impact on the rich and highly globalised economies.

The major factors of the Great financial Recession are as follows:

a) Housing Bubble Scam of U.S The housing bubble was a major cause of sub-prime crisis. Once the low, introductory interest ('teaser') rates on sub-prime loans came to an end, the delinquencies registered a steep hike. The rise in bad loans subsequently led to the failure of a number of US mortgage lenders. Followed by a surge in the risk perceptions and decline in lending which was greatly exacerbated by failure of Lehman Brothers in September, 2008; an event which that almost caused the financial system to implode.


All things led to the bursting of the housing bubble in the US and storm started with immense power from US & was ready to hit world’s economy. The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; an explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.

b) Subprime Lending

Due to the high competition in the market the underwriters relaxed the standards of lending and made available the riskier mortgages to the less creditworthy borrowers. The Government Sponsored Enterprises policed mortgage originators were relatively conservative and this relation in lending standards shifted the power from securitizers to the originators due to intense competition undermined the GSE power, decline in the standards, risky loan proliferated.

Low interest rate

borrowings by Households

Lender sold the mortgages

to FIs.

FIs issued mortgaged

backed securities (MBS)

Pool of MBS with Private sector

(CDOs)

Increase in Credit default

Swaps


Financial regulations were weak and administrations led by Clinton and Bush also didn’t work much to perceive the BIG RISK coming to their way. Facts proved that subprime lending was also a big reason for the financial crisis along with Housing Bubble.

Trends spoke that 305cities from 1993 to 1998 showed $467 billion of mortgage lending by Community Reinvestment Act (CRA) to Low and Middle level income (LMI) represents 10% of US mortgage lending. 25% of all sub prime lending was related directly or indirectly to CRA covered institutions.

Critics also point out that publicly announced CRA loan commitments were massive, totaling $4.5 trillion in the years between 1994 and 2007. They also argue that the Federal Reserve’s classification of CRA loans as “prime” is based on the faulty and self-serving assumption: those high-interest-rate loans (3 percentage points over average) equal “subprime” loans.

All big names like Krugman, Denice A. Gierach, Economist Paul Krugman, Wallison, Xudong An and Anthony B. Sanders and others wrote and opined in their own style and understanding.

The crux is the real estate loans were not bad loans it was the combined factors that made them bad.

c) Housing Bubble at its PEAK

The crux was there was a pool of money and money was moving in a cycle, like from household to lenders, to FIs, to securitizers, to others and then back to households getting riskier and riskier day by day.

Increase in External Finance

(which includes export

revenues, remittances and

private capital flows.)

Increase in

consumption

in advanced

economies & Increase in

investments &

exports in

developing countries

Cost of

Capital

decreased


d) OTHER REASONS

a. Easy Credit conditions b. Weak and fraudulent underwriting practices. c. Predatory Lending d. Deregulations e. Over leveraging f. Lack in perceiving the unprecedented risk

DIVERSIFIED IMPACT OF THE CRISIS:

Despite the severity of the crisis, there has been a great deal of diversity in how different countries have been affected by the downturn in terms of both magnitude of economic contraction and subsequent deterioration of the financial & labour market.

Financial market collapsed and Dow Jones Industrial Average index exceeded 14,000

points. It then entered a pronounced decline, which accelerated markedly in October 2008. By March 2009, the Dow Jones average had reached a trough of around 6,600. Four years later, it hit an all-time high. It is probable, but debated, that the Federal Reserve's aggressive policy of quantitative easing spurred the partial recovery in the stock market. Market strategist Phil Dow believes distinctions exist "between the current market malaise" and the Great Depression. He says the Dow Jones average's fall of more than 50% over a period of 17 months is similar to a 54.7% fall in the Great Depression, followed by a total drop of 89% over the following 16 months

Financial institutions also suffered the huge losses of all lifetime highs. The International

Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007 to 2010. U.S. bank losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The International Monetary Fund (IMF) estimated that U.S. banks were about 60% through their losses, but British and eurozone banks only 40%

Economic Consequences: The US was the epicentre of crisis and its economy was hit directly by the meltdown in sub-prime mortgage market along with the repercussions of the financial crisis and the ensuing credit crunch. The recession hit US economy in December, 2007 and the economy shrunk by 2.7% in 2009.


Diversity is a hallmark of the Great Recession of 2008-09. This can be justified by the fact that countries in the Asia region (namely China, India and Australia) avoided a major contraction despite their integration with the global economy. Ethiopia and Uganda also continued to grow strongly. The worst affected ones include Lithuania, Latvia, Armenia, Estonia and Ukraine.

Impact of Crisis on the Labor Market: In OECD countries, unemployment rate increased by more than 50% within a span of two years (from 5.7% in third quarter of 2007 to 8.6% in third quarter of 2009). This represented a rise of 10.1 million in individuals without jobs. According to ILO's Global Employment Trends (Jan 2010) the number of unemployed persons increased by approximately 34 million during the above time span. 5 hardest hit OECD countries were Estonia, Spain, Ireland, US and Turkey. To our surprise, Poland & Germany saw a decline in the unemployment rate during the same time frame.

ROAD TO RECOVERY: POLICY RESPONSES:

i. Macro-economic Policy: As the global financial crisis unraveled, governments across the globe increasingly recognized the severity of the downturn and the urgency to intervene in order to avoid a catastrophic collapse of the financial markets and real economy. The response has consisted of the following interventions – the first three being the main interventions:

Bailouts and injections of money into the financial system to keep credit flowing in the form of fiscal stimulus packages; Cutting interest rates to stimulate borrowing and investment; Extra fiscal spending to shore up aggregate demand; Stimulating labor demand; Supporting jobs and unemployed; Expanding social protection & food security; Using social dialogue and protecting rights at work; Corporate tax reductions; and Increased capital expenditure (in the form of infrastructure programs).

ii. Labour Market and Social Policies: As an immediate reaction to the crisis, there were dismissals, mass layoffs, plant closures, hiring freezes in order to adjust the labour demand. Consequently, the unemployment rates increased. Now, the ball was in the government's court and it took several challenging decisions in order to curtail the havoc of the virus of unemployment. Few of them have been mentioned below: Maintaining and increasing labour demand; Improving the match between demand and supply;


Providing income support; Targeting of vulnerable groups; Training for both – those threatened by layoffs and unemployed; Work-sharing; Increased resources for public employment services; Job-search assistance measures; and job/wage subsidies; and Public works program to generate new employment opportunities.

FROM RECESSION TO RECOVERY:

i. Economic Recovery (slowly taking hold): Towards the end of 2009, a variety of indicators showed that the worst of the global financial crisis was over in most countries. Stock Markets recovered; Trade and industrial production statistics improved; Manufacturing activities showed positive signs; Capital formation was expanding; Output escalated; and Exports increased; All the above factors contributed to rebound in global trade to the recovery. Most importantly, expansion in the US and Japan appeared to gather pace. 20 out of the 30 OECD countries had technically exited the recession by the fourth quarter of 2009.

ii. Labour market still remained in crisis: As it is said, 'the real test of recovery is not whether the economy is back on track but whether there are signs of improvement in the labour market.' So, in these terms, the recession wasn't over yet because unemployment continued to raise in the vast majority of the OECD countries. Layoffs peaked early in 2009 before returning to pre-crisis levels. The peak occurred in January 2009 when almost 3,82,000 pending dismissals were announced globally. Reduced job openings and subsequent collapse in hiring helped in magnifying the effects of recession.

Few extra points observed:

I. An ideal government should focus on following during the recovery phase: Continue to keep workers in jobs; Utilize job/wage subsidies along with tax credits to encourage hiring of new staff by employers; Strengthen re-employment policy by taking measures in respect of providing assistance in job search and training; thereby, improving the employability of the unemployed. This will help to eradicate long term unemployment and ensure that their skill doesn't remain under-utilized.


II. The banks that survived the crisis had turned in record profits in 2009. Credit for which goes to the benefit from government bailouts and injection of liquidity into the financial system, decrease in competition – a market without the likes of Bear Stearns, Lehman Brothers and Merrill Lynch. The most profitable being Goldman Sachs which reported a record net profit of US$ 13.4Billions in 2009.

The challenge is to develop a regulatory system that will prevent the similar risk-taking behavior witnessed in 2008-09 that led up to the sub-prime crisis.

CONCLUSION: 1. The crisis of 2008-09 was not a result of the sudden bankruptcy of Lehman Brothers but was in fact a result of the numerous crises that took place during the Great Moderation and the Lost Decades, along with the food and oil price shocks in 2007. These were termed as 'crises before crisis.' But the fact was easily forgotten during the boom years of 2000s. The crisis should not have come as a surprise after all these warning signs. 2. A complete range of complex and interlinked factors was behind the emergence of global financial crisis in 2007. These include loose monetary policy, global imbalances, misinterpretation of risks and lax financial regulations.

3. Also, there was diversity in the way the Global Recession impacted the different nations. This was eventually the reason behind the differences in the approaches of various governments to overcome the recession, i.e., in the policy regulations and measures adopted to combat the crisis.

Supported By Ashita Chauhan Karanjeet Singh

Pankaj Written By

the great financial risk crisis 2008-signed

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